Why you need to over-save if your retirement funds are in the stock market

In recent decades the conventional wisdom has been that people should invest the majority of their retirement savings in the stock market. The conventional reasoning goes like this:

  • The stock market has a historic rate of return of 10% over the long term, which is much better than the other investment choices.

  • There is risk in stocks, and the stock market can drop in the short term, but it always comes back up in the long term.

  • Your retirement is off in the future, so you are investing for the long term and short term downturns don't matter.

  • Your retirement will last a long time so even in retirement you will be investing for the long term.

  • If you don't take risks your investments won't make enough money and you won't have enough money to retire when you want to, or to spend as much as you want to in your retirement years.

Do you find yourself nodding your head in sage agreement with this sound advice? Taking risks; getting high returns; thinking in the long term.

Now lets look at what the purveyors of the conventional wisdom have to say when there is big downturn in the stock market:

"Q. But what if I am about to retire? Then what?

A. Leaving the work force at a time like this creates big problems. Not only is your portfolio down, but you need to start withdrawing from it. So you are essentially locking in your losses.
If your portfolio has taken a big hit, it may be time to seriously consider delaying retirement. Working just a few years more can make a big difference. Or, a part-time job may keep you from having to dip into your portfolio before it recovers."

From "Is My Money Safe" New York Times, 29 Sept 2008

"Fortunately, you can soften the blows of retiring in a slumping market. Here are some ways to help make sure your savings last as long as you do:

WORK LONGER AND SPEND LESS. This may sound obvious, and somewhat depressing, but working just a few years longer can make a big difference.

From "Retire Now, and Risk Falling Short on Your Nest Egg" New York Times, 16 August 2008. See also "Retirees Filling the Front Line in Market Fears" New York Times, 22 September 2008.

Now wait a second. You were investing in the stock market so that you wouldn't have to work in your golden years, and so that you wouldn't have to pinch pennies. And now they are telling you that you need to delay retirement, and spend less in retirement exactly BECAUSE you were savvy and invested your retirement in the stock market? Our savvy strategy got us the the exact result we were trying to avoid?

The problem with the conventional wisdom is that it doesn't consider one of the most important realities of retirement: You will need to withdraw money from your retirement fund on a fixed schedule over a long period. There are invariably one or more substantial stock market downturns during any given 20 year period, and so invariably the person with all of their retirement savings in the stock market will have to sell some portion of their portfolio when the market is down at some point during their retirement. And once you sell when the market is down it is impossible to realize the long term average return on your portfolio because that long term average assumes you never sell.

Since you will need to be withdrawing your money on a fixed schedule the long term return of the stock market is irrelevant to you. You don't care if over time it will eventually return 10% for someone who never had to sell their stocks. What you care about is what the return will be if you have to start withdrawing a fixed amount every year starting at age 65. And guess what? No one can tell you what that rate of return will be because its impossible to calculate or predict. If you are really lucky the market will stay up for your entire retirement. But what is more likely is that there will be a substantial downturn sometime during your retirement, and you will need to sell stocks at a loss just to keep your up with your expenses, and then your retirement fund will be crippled for the rest of your retirement because you had to liquidate at a bad time, and you will be in the exact financial place you were trying to avoid.

Another reality that the conventional wisdom ignores is that things come up and you never know when you are going to need to suddenly make a larger than expected withdrawal from your retirement fund. People lose jobs. Family members get disabled. Your child gets mixed up with the law. The big house you bought with an adjustable rate mortgage loses value and you have to sell at a loss because you got transferred and in order to close the sale you have to pull money out of your retirement fund to make up the balance on your mortgage. Stuff happens, and if it happens during a market downturn you could be forced to sell stocks at bargain prices and be left in the exact situation you were trying to avoid.

At this point conventional wisdom follower is shaking her head and has a knowing little smile because she knows that even though stocks are risky people who invest in stocks are still going to be better off in the long run than people who invest their retirement in bonds or (horrors) CDs, because the stock market investors will still get a better rate of return on average and so no matter what the stock investors will probably have more money in retirement. Which will probably be true most of the time if you assume the same amount of money invested in stocks vs. CDs. However, what if the perceived high rate of return in the stock market causes someone to save less?

Imagine you are in your 20s and you are starting to make plans for retirement. You carefully calculate the annual income you want to have in retirement, and then you calculate how much you need to be saving now to reach that goal, assuming (of course) a 10% return since you are savvy and will invest in the stock market. Thanks to the high returns available to the savvy stock investor it turns out that you don't have to save that much of each paycheck, and so you can afford to spend lots of money on lattes and nice cars and big houses. Meanwhile your clueless neighbor invests everything in low yielding but safe investments, and since they need to save more of their paycheck they have a plainer car, make their own coffee, and spend less on their home. Fast forward 45 years. The stock market crashes just as you reach age 65 and suddenly your retirement fund shrinks to less than that of your clueless neighbor. You need to postpone your retirement, sell your nice car, drop the lattes, and pray the market recovers before you are 80. Your clueless neighbor's retirement starts right on schedule and she has exactly the amount of money for retirement that she was expecting.

Here are some illustrative numbers. I put together a spreadsheet using Robert Shiller's stock market data and compared two hypothetical people who steadily invested a fixed percentage of the US median household income every month from 1968 to 2008, the year they both plan to retire. One person put 10% of median household income in the S&P 500. The other invested 20% of median household income at long term interest rates. Here's how they compared last year:

October 2007
10% of income in S&P: $1.1 million
20% of income at long term rates: $762,000

The safe investor sure looks like a chump and the stock investor is looking forward to a relatively lavish retirement. But lets look again a year later:

23 October 2008
10% of income in S&P: $646,000
20% of income at long term rates: $802,000

The stock investor has seen her nest egg diminish to almost half its size a year ago and her life has been turned upside down. The safe investor has had no disruption. Note that the stock investor, even with the market downturn, got a higher rate of return than the safe investor. And the stock investor was able to spend more money during their working years. But that didn't protect the stock investor from having her her retirement plans thrown out the window. And if the stock investor retires on schedule, she will pull money out of the market when its down, which will reduce her overall rate of return in in coming years.

The moral of the story: if you save for retirement assuming a high rate of return from stock investments you need to be prepared to suddenly find yourself with much less money than you were expecting to have.

So whats the answer? The answer is that if you want to be sure of having a certain annual income in retirement then during your working years you have to save, and spend, at a rate that assumes a low rate of return. If you save like all your money was invested at 4%, and you spend in retirement like your money was invested at 4%, then you can probably afford to have some or all of your retirement fund in stocks since you will probably be able to sell stocks at a loss during a downturn and still have enough left over.

Another possibility is to start off investing all your retirement funds in the stock market when you are young, but then start moving money out of the stock market and into conservative investments starting 10-15 years before your planned retirement (when the market is up, of course) with the goal of having at least 5 years living expenses in very safe investments when you reach retirement.

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